ECB flags December hike but sees yield rise hitting growth

By Balazs Koranyi and Francesco Canepa

FRANKFURT, Oct 29 (Reuters) - The European Central Bank left interest rates unchanged in a well-telegraphed move on Thursday but clearly hinted at another hike in December with a warning that high and rising energy costs were fuelling inflation risks.

The ECB has raised rates twice this year to prevent an Iran war-induced energy price jump from becoming entrenched and has signalled that more may be needed, even if it was not in a hurry without evidence of dangerous second-round inflation effects. 

In a decision published hours after ECB President Christine Lagarde announced she would step down early, the ECB warned risks to inflation were skewed to the upside given a recent surge in oil and gas prices.     

Lagarde went even further during her post-meeting press conference, saying the direction of travel for rates was clear and that policymakers had debated a hike on Thursday before agreeing to wait until December to gather more data.

"The interim meeting period will be information-rich," Lagarde said. "That will actually help us determine whether the situation that we see now, which could have warranted a hike, is going to be confirmed, and in that case the sense of direction is quite clear."   

Sources at the meeting told Reuters a hike on December 17 was now all but certain given the surge in energy prices but policymakers expected to pause thereafter in light of a recent, sharp rise in market-based borrowing costs.

ECB estimates circulated before Thursday's meeting showed that the latest increase in bond yields would lower economic growth by a cumulative 100 basis points and inflation by 90 basis points in 2027-28 compared to the September baseline projection.

FRANCE DEBT MARKET TENSIONS

The euro zone's central bank will have to walk a narrow path in the months ahead.

On the one hand, it is battling to prevent high global energy prices developing into a longer-term inflation problem for the 21-country currency bloc.

On the other, it is having to contend with sharp rises in government borrowing costs — especially in debt-laden France — that have triggered questions about whether it would step in if the market moves threatened to get out of control.

Lagarde stressed that governments needed to comply with the European Union's fiscal rules to qualify for ECB help under its Transmission Protection Instrument. 

"Should market developments threaten the smooth transmission of our monetary policy, including through unwarranted and disorderly market movements, we have instruments available to respond," she said.

Economists have also warned the increase in borrowing costs is likely to curb the flow of credit and slow the economy. France is now having to pay a decades-high 155 basis point premium over Germany to borrow for 10 years.     

"We think we are probably quite far away from a situation in which the ECB would intervene in bond markets," economists at ABN AMRO wrote. "However, the ECB might be firing a warning shot." 

Lagarde said that bond market yields were likely to stay high for heavily indebted euro zone members, which the ECB needed to take into account when setting rates.

This is why the vast majority of economists polled by Reuters see just one or two more hikes before the current tightening cycle ends.

"Although the ECB remains data-dependent and is not committed to a specific interest rate path, the overall tone has shifted toward fewer rate hikes," Ulrike Kastens, a senior economist at DWS, said.

(Reporting by Balazs Koranyi and Francesco Canepa; Editing by Catherine Evans)